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How to Build a Diversified Portfolio Using ETFs

The ETF revolution is here. Exchange Traded Funds have gone from essentially not existing only 15 years ago, to holding more than $1.5 trillion in assets today. And since the 2008 financial crisis, they have been taking massive share from the actively-managed mutual fund complex.

There are some very good reasons for this. Exchange Traded Funds (ETFs) provide a great way for individual investors to build globally diversified portfolios using only a handful of securities. The power of ETFs comes from their unique combination of the best elements of the stock and mutual fund worlds. Like stocks, ETFs can be bought and sold in real-time from any discount brokerage account. Like mutual funds, ETFs are diversified investments that may own hundreds of stocks or bonds.

If you want to get investing in ETFs, one option is to try a free trial to IvyVest premium. We provide you with a real-time updated version of our rules-based dynamic asset-allocation model, tools and calculators that will tell you exactly what to buy and when and how to rebalance, and a monthly members-only newsletter to keep you on track. But if you decide the service is not for you, it is also possibly to setup and maintain a rational portfolio entirely on your own. This article will show you a framework for doing just that.

Figure Out Your Asset Allocation Strategy

The greatest determinant of the returns of any diversified portfolio is its asset allocation. Before deciding how much of your portfolio to invest in US Stocks, European Stocks, Treasury Bonds, and the rest, a necessary first step is to decide on an overall asset allocation strategy. There are two good choices:

Static Asset Allocation. Under this approach, you choose your asset allocation based on your risk tolerance and long-term adjusting goals, and don't change it (unless your life cirumstances change). This is the approach that is followed by most financial advisors, and it is what we would recommend to investors that choose to entirely "do it themselves." Under a static approach, you still might make occasional changes to your portfolio, but they will be to "re-balance" back to your initial weights.

Dynamic Asset Allocation. Under this approach, you make periodic adjustments to your asset allocation based on what is going on in the market. For instance, if US Stocks have gone up a lot and now appear to be in a bubble, you might decrease your holdings of them and increase your holdings of another asset class like gold, real estate, or emerging markets stocks. This is the approach that the IvyVest model takes, but we would not recommend it to most investors that choose to go it alone, because it is difficult to successfully make these kinds of shifts without having access to a backtested and data-driven rules-based framework.

The rest of this post will assume that you have chosen to use a static asset allocation, as the subject of developing your own dynamic asset allocation framework is beyond the scope of this post.

Decide How Many ETFs and Asset Classes You Want to Own

The ETF market has evolved to the point that it is easy to own as many, or as few, ETFs as you would like. Get a diversified portfolio in practically one ticker, or customize allocations to your hearts desire, the choice is yours. The advantages of owning a greater number of ETFs include:

Flexibility. Ability to take more nuanced views and exposures by more closely controlling the weights of one asset class — like US Stocks — relative to others like bonds or real estate.

Diversification. All else equal, owning more funds may allow you to add more asset classes to your portfolio, which can reduce risk.

The advantages of using less ETFs include:

Simplicity. A portfolio of only a few ETFs requires less time and effort to manage.

Lower transaction costs. Transacting in several ETFs every time you want to add money or rebalance a portfolio can meaningfully increase commissions, though, again, using a brokerage with commission-free ETFs can mitigate this.

Below, we suggest some potential static portfolios for varying levels of simplicity, starting with a one-fund portfolio.

A One Fund Portfolio

The Choice: Vanguard Retirement Date Fund (ex: VTTHX, These funds are currently only available in mutual fund format)

If you are going to only hold one fund in your portfolio, you will want it to be one that can provide a one-stop way to get the diversification benefits of owning multiple different asset classes. Vanguard's retirement-date funds fit the bill, and come with a rock-bottom expense ratio that averages .18% of assets, and a professionally managed asset-allocation that automatically becomes more conservative as you approach your retirement date.

One-stop shops don't get much better than this. Just pick a fund with a date close to your retirement date (they come in five year increments) and you get an appropriate mixture of stocks from the US, Japan, Europe, and emerging markets as well as US bonds. While the resulting asset mix might not be totally optimal for everyone, it is generally well thought-out.

Three Fund Portfolio

While a Vanguard Retirement Date Fund is okay as portfolios-in-a-box go, using more funds can have its advantages. When adding ETFs to a portfolio, you must decide whether you want to add an additional asset-class not already in the portfolio, or whether you want to split a broader fund into its parts, which gives you more flexibility in your asset-class weightings.

We would split the difference and use one additional ETF to split apart stocks and bonds, enabling you to create a more customized weight there, and another to add REITs to the portfolio, an asset-class that Vanguard leaves out of its retirement-date funds. The three new funds are profiled below:

The Vanguard World Stock Index Fund includes about 50% North American stocks, with 25% from Europe, 14% from emerging markets like China, Index, and Brazil, and 11% from Japan. This is an acceptable mix of stocks for most people.

The Vanguard Bond Index Fund tracks a broad index of US Treasury, mortgage-backed, corporate, and agency debt, providing a lot of punch for the price.

The Vanguard REIT Index Fund tracks a broad range of US Real Estate Investment Trusts — special companies that buy apartment buildings, office buildings, and other commercial real estate. Real estate can perform well in "stagflationary" (high inflation and low growth) environments when stocks and bonds do not, so it is a worthy addition to a portfolio of stocks and bonds from a diversification perspective.

All funds have industry-low expense ratios and are highly diversified and well managed. As for weights, we would start with: 50% VT, 30% BND, 20% VNQ and customize it to your tastes from there.

A Five Fund Portfolio

If you are going to use five ETFs to implement your portfolio, then choices abound. Starting with the three ETF portfolio, we suggest using one additional fund to add gold as an asset class, and the other to split stocks into US stocks and international stocks in order to get more granularity.

The choice of including gold is likely to be the more controversial view here, as the yellow metal seems to divide investors on quasi-religious grounds. We include it because we find the "gold as insurance against a collapse of the global monetary system" argument compelling. With government printing presses running at a full clip, there is a chance that investors lose confidence in monetary systems in the next few decades. As a traditional store of value, gold could be one of the few things to hold up well in this kind of environment. Not that we are predicting this, just saying it is a possibility....

Splitting apart US and international stocks is less controversial, and allows investors to customize their level of international exposure and diversification.

With an eight ETF portfolio we have the luxury of making three additional changes.

First, we split international stocks into emerging markets stocks and international stocks, which allows for a more flexible risk posture. This is important because those with a more aggressive risk tolerance — or a more positive view of the world economy — might want to buy into highly volatile emerging market economies more than those with a faint heart or a more bearish worldview.

Second, we add TIPs and commodities to the portfolio. TIPs are included in Vanguard's main bond index fund that serves as a foundational piece for all the proceeding portfolios, but they have very different properties than nominal bonds, so are worth breaking out on their own if you have the luxury of doing so. TIPs play an extremely useful role in a diversified portfolio because they are a risk-free asset that also performs well in inflationary periods when stocks and nominal bonds are likely to suffer.

Commodities, on the other hand, are not included in any of the previous portfolios (though some may argue that they should be included in place of gold), but they can play a unique and vaue-adding role in a portfolio by holding up both in an inflationary period where stocks and bonds may suffer while also gaining in value if the world economy goes back into over-drive and we run into resource constraints as a result of growth in emerging markets like China and India. The Power Shares ETF invests in commodities through the use of futures contracts.

So How Much Diversification is Necessary?

As proponents of "extreme diversification" we think that a portfolio should go beyond just stocks and bonds. It is possible to imagine a future world - one that could a lot like the stagflationary 1970s in fact - where stocks and bonds both underperform but gold, commodities, and real estate have good runs. So we would reject the one fund Vanguard solution as being not quite diversified enough.

At a minimum we would include stocks, bonds, gold (or commodities/TIPs), and real estate as asset classes - which puts you at four to six ETFs depending on how many you want to devote to the equity allocation.

Figure Out Optimal Weights in Each ETF

One you have selected your investment universe, it is time to allocation percentages of your portfolio to each ETF or asset-class. There are two approaches to this: the mathematical approach, and the rules-of-thumb approach.

The mathematical approach involves picking the mix of assets that offers the highest return for the amount of risk that you are comfortable taking. The technique used to do this most commonly is known as "mean-variance optimization." Unfortunately, to do this you need to be able to estimate the future expected returns and correlations of a broad array of asset classes.

The more practical approach for DIYers is to use "rules of thumb." One such rule, for instance, is that a "balanced" portfolio should consist of about 60% growth assets like stocks, and 40% defensive assets like bonds. We think this is a good starting place. Investors with a higher risk tolerance (which tends to go along with being more experienced, being younger, and needing to achieve higher returns in the future to meet a goal) might want to adjust the mix of assets slightly upwards (more towards stocks). Investors with less risk tolerance might want to include more defensive assets like bonds.

In growth assets, we would include stocks, commodities, and half of your real estate allocation.

In defensive assets, we would include bonds, TIPs, gold, and half of your real estate allocation.

A few other rules of thumb that might be helpful:

For US-based investors, US Stocks should probably encompass between 50 and 75% of the overall stock allocation. 50% would be more of a pure "market-cap split" whereas 75% would be a bit of a "home country bias", but might still be rational. If less than 1/4 of your stocks are ones based outside of the US, you are probably losing out on some diversification benefits.

5-10% is a good range to hold in "alternative" assets like commodities and gold. Above this level, they may start to diminish the returns of your overall portfolio. Below this level, it's not clear they are going to make enough of an impact to justify the effort of buying them.

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